Everyone knows stock trading is risky. While a lot of people don’t partake in the market because they’re afraid to lose money, there are others who indulge in even riskier forms – like options trading.
While the concept of options trading itself is very well-established, the Strangle Strategy is more niche and detailed. Let’s dive into how to trade options with the strangle strategy.
Introduction to options trading
To better understand the intricacies of the strangle strategy, we think a quick options trading refresher can do no harm. Here are some basics.
The basics of options trading
Options trading is a form of derivative trading where instead of buying and selling actual stocks, you buy the ‘right’ (but not obligation) to buy and sell. However, this has to be done at a specific price (the strike price) and by a certain time (expiration date).
Options are of two types:
- ‘Call’ option, which lets you buy, ‘Put’ option, which lets you sell.
A call option lets you purchase a stock at a fixed price before the contract’s expiration date. If the stock’s market price rises above that strike price, you can buy it at the lower strike price, allowing for potential profit.
If the stock price stays lower, you might choose not to use the option, losing only the initial cost. A put option is basically the same thing but with selling stocks. Puts are used when you expect stock prices to fall. When they do, a put option can help you sell higher than the market price.
You may also like: How to trade in options and maximise your profit?
The strangle strategy
Now that you’re all caught up on how options trading works let’s dive into the famous Strangle Strategy. An options strangle, which is how this move is generally known in investment circles, is a tactic used to make gains based on the prediction that there’s going to be big movements in a stock in a short time.
This strategy basically involves buying a call option with a strike price above the current market price of the stock and, at the same time, investing in a put option with a strike price below the market price.
This strategy lets you profit from big price moves, regardless of whether a stock goes up or down. This is how.
- The call option, which is bought to profit from stock price rises, will make you money if prices go up.
- The put option, which lets you profit from stock falls, hedges your bets if things go wrong.
Here’s how this works in the real world.
Imagine a stock is trading at ₹100. You buy a call option with a strike price of ₹105 and a put option with a strike price of ₹95. If the stock climbs above ₹105, the call option could become valuable, making up for the put option's cost. If the stock drops below ₹95, the put option might become profitable instead. Remember that the goal is to capitalise on these movements. If your predictions turn out inaccurate and the stock doesn’t move either way, you are left with no choice but to let your contracts expire and bear the premium cost of two options. This is the reason why this strategy is helpful only when you’re expecting a big price change in the stock but aren’t sure about the direction.
Strangles in options trading can work in two directions:
A long strangle –
The long strangle is what we’ve described above in the example. Here, an investor buys a call option where the strike price is way higher than the stock’s current trading price (which is also called an out-of-the-money call) and a put option that’s way below.
Both bets are currently out of the money. However, potential volatility in this stock inevitably benefits the investor. The risk, however, is limited only to premiums paid while buying the call and put.
A short strangle –
A short strangle comes from the other side of the trade – the options writer. Here, the writer sells one out-of-the-money call and put option each simultaneously.
This strategy is the opposite of the long strangle – it has limited profitability and unlimited risk. Short strangles are taken when investors feel that the stock price is not going to experience a lot of volatility and will remain relatively stable.
Here, the profit is limited to the premiums received for writing these options and the risk depends on how volatile the stock turns out to be.
Benefits of the strangle strategy
- Unlimited upside – Since strangle options are only undertaken when investors experience major price volatility, the chances that one of the two options will get executed is high.
Since the price movement has theoretically no limit, the upside to the trader is also limitless, no matter where the stock moves.
- Reselling options is a way out – If you think your options will not be executed profitably near the expiry date, you could always sell your options to reduce your losses or even book some profits.
- Limited loss – Even if the stock stays at exactly the same price it was when you bought the strangle options, you only end up losing the premiums you paid.
Are the strangle and the straddle the same?
They’re mostly similar in the sense that they allow investors to profit from volatile moves in the stock’s market price. However, a straddle is a little different in execution.
Both the call and put options in a straddle have the same strike price and expiration date. If the asset’s price moves significantly in either direction, the gains from one leg of the straddle could potentially offset the losses in the other leg, making a net profit.
Strangles, as you know, have different strike prices. A strangle is usually cheaper to implement than a straddle, as the options purchased have different strike prices. However, since profitability only comes with significant price moves, strangles are also less likely to make money than straddles.
While the Strangle strategy might seem like the golden move with its unlimited upside and limited downside, there are a lot of nuances that we haven’t been able to cover in this video. Traders and investors have to keep in mind not just their strategies but also other metrics like the macroeconomic weather, the stock’s fundamental strength, and the trade’s technical soundness.
Make sure that you’re doing your own research before trading too much money. Good luck!